Index Funds: The Way to Go for Retailers?

By Echelon.

Published on January 19, 2015 with No Comments

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After several miserly years the Colombo  Stock Market (CSE) saw a welcome rebound in 2014. With a year to date gain of almost 25% the CSE has been one of the best performing markets in the region and the world. The performance of the S & P 20 -made up of the largest (in terms of market capitalization) and most liquid stocks – has been similarly bullish. Record levels of participation by foreigners have played a part in CSE’s fortunes. On the other, local interest rates languishing at record lows have pushed many to invest their deposits in the market. Many such former depositors have done so with much apprehension – after enjoying years of high yields on deposits, coming to grips with uncertain returns. The possibility of losses is a difficult prospect.

This is compounded by the fact that most such former depositors have little knowledge of the market or managing equity investments. Hearing horror stories of investors who have lost their life savings following recommendations of dubious experts or ‘pump and dump’ schemes of unscrupulous large investors would have not helped their nerve either. Though not very popular in Sri Lanka Index funds and mutual funds remain the best options for such investors. Mutual funds are investment pools managed by fund managers. Index funds is a passive investment strategy simply mimicking the market index by buying into all securities that make up the index, in the same proportion as the index.

Naturally index funds are easier to administer, and thus generally carry lower fees and transaction costs. Furthermore, research has proven that managed funds underperform the benchmark – in other words the index – over time. Years of high returns are cancelled out under-par performance in some years. This is quite rationally only to be expected as picking the winners, within the noise and false signals of a stock market is next to impossible. As Jack Bogle the founder and Chairman of Vanguard famously put it “why look for a needle in a haystack, when you can buy the whole haystack?”

While the diversification of an index fund offers more security to a cautious investor, the returns still do vary with the fortunes of the index. Much like all other frontier markets the CSE too tends to be highly volatile. Also index funds make most sense in developed markets, where the availability of information and large number of highly competitive market participants combine to compete away any competitive advantage. In markets such as ours where the majority of the market isn’t privy to all information and lack the financial literacy to make sense of available data, there could well be a tangible advantage in adopting an active investment approach.

The coming year is likely to see more retailers entering the market buoyed by the good performance of this year and forced to look for higher yields in a low interest rate regime. For many of them an indexing strategy would still be advisable for the following reasons.

Much of the positivity surrounding the market is based on the overall growth trajectory of the economy. While some sectors will outgrow others, the rising tide should lift all boats. Rather than trying to pick individual winners – be it companies or industries – and risk putting too many eggs in one basket, an indexing strategy would capture this upside. Secondly, indexing as a passive strategy incurs less transaction costs than an active fund allocation. The tendency to over trade and incur high transaction costs is particularly high in a bull market. In Sri Lanka stockbrokers habitually function as both advisors and traders – executing the trade. This is particularly true for retail accounts, where the client enjoys less access to the broker’s research department and analysts etc.

In such instances there is a conflict of interest as a broker incentivized by commission (earned on transactions) is likely to encourage more trading than optimal. Such overtrading is sometimes initiated under the guise of trading on a hot insider tip or following a larger investor, both popular ruses for enticing investors into pump and dump schemes.

The enforced discipline of an index strategy protects novice investors from such risks.

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